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Putin's oil weapon about to backfire

Andrew Critchlow

Russian president Vladimir Putin's threats to turn off oil supplies could backfire spectacularly if he tempts the US back into the export market. Photo: AFP

Oil prices are on the brink of possibly their biggest correction since the global financial crisis after Vladimir Putin's gamble to use Russia's crude as a political weapon backfired spectacularly on the Kremlin.

A potent energy superpower, Russia had thought that it could use its status as the world's largest oil producer and biggest exporter of natural gas through cross-border pipelines to intimidate and quite literally bully Western powers into submission over Ukraine.

The mere suspicion among oil and gas traders that the country's president would turn off the taps on the thousands of kilometres of pipelines that snake their way from fields in Siberia's steppe to export terminals and urban consumers in Europe – in retaliation for economic sanctions imposed by the US and Brussels – had been enough to keep energy markets artificially frothy.

The risk premium on Russian supplies that had inflated oil prices came at a time when many experts were beginning to warn of too much crude sloshing around on world markets.

Brent oil – a global benchmark – had gained about 10 per cent to comfortably trade above $US110 per barrel since February, when the regime of the then Ukrainian president Viktor Yanukovych came crashing down under the weight of protests in Kiev's Independence Square.

Ole Hansen, head of commodity strategy at Saxo Bank, has now made the bold call that about $US25 could be slashed off the price of a barrel of crude if the US government were to open its huge stockpiles of oil stored in the nation's Strategic Petroleum Reserve (SPR).

Set up in 1975, the reserve was intended to provide at least 90 days' worth of imports to protect Americans from the kinds of intermittent "oil shocks" that two years earlier, during the Arab oil embargo, had seen petrol pumps run dry.

The reserve was first seriously tapped into in 1990, when coalition forces launched military action to evict Saddam Hussein's Iraqi forces from Kuwait.

In 2005, 11m barrels were released in response to Hurricane Katrina, and in 2011, Washington again offered to place crude on the market from the SPR to ease pressure on markets after production in Libya was knocked out by the civil war.

The reserve, which is held in huge tank farms across America, now contains 700 million barrels of crude, enough to meet the entire world's oil consumption for almost eight days. According to Hansen, most of it was accumulated at an average cost of about $US30 per barrel – a significant discount to current prices.

Aside from making a big profit, releasing oil from the SPR would be one of the American government's most effective strategies to nullify Putin's "energy weapon" and humble the Russian economy further.

The Department of Energy gave traders a small taste of the SPR's potential in March, when it unexpectedly placed 5 million barrels on the market. The release was a rare move that many experts interpreted as a tacit warning to the Kremlin to keep its oil and gas flowing as it annexed Crimea.

At the same time, Hansen points out, US domestic crude inventories are surging. According to the latest figures available from the US Energy Information Administration, America was producing 8.3 million barrels per day (bpd) of crude last month, the highest level achieved since 1988.

At this rate, the US government will soon have no alternative – irrespective of the situation with Russia – but to lift its ban that was first introduced in 1979 on domestic exports of oil.

"Although the world is mostly focused on the risk of oil prices spiking higher, there is another dimension in this story, which could completely change the outlook," said Hansen.

"A resumption of US exports would seriously alter the global oil market, which is already seeing supply growth rising faster than demand, and it is not difficult to envisage a drop in Brent crude."

Saudi Arabia is sitting on about 2.5 million barrels of spare capacity, while Iran and Iraq harbour ambitions to at least triple their output in the medium term. Even if the 12-member Organisation of the Petroleum Exporting Countries were to agree to cut production at its next meeting, it's unlikely that many of its members would comply in the current environment, in which producers must chase market share.

Regardless of the fracking revolution in the US, the world appears to be flooded with crude.

According to Hansen, this would not be the first time that Russia has had the "oil weapon" turned against itself. In 1986, Saudi Arabia gave in trying to keep oil prices stable after the Kremlin increased oil production at its expense.

Hansen said that Riyadh was subsequently forced to reduce production in order to keep prices stable. "Once the kingdom began increasing production in 1985 and 1986, oil prices collapsed from around $US30 per barrel before bottoming at $US10.50 per barrel in March 1986. The result of this was a massive loss of revenues for the Soviet Union, and it most likely played its part in the Soviet disintegration a few years later in 1991."

But flooding world markets with US oil could be ruinous for many of Washington's closest allies in the Middle East and arguably destabilising for the rest of global economy. Therefore, Hansen argues that such a move would be unlikely unless provoked by Russia, which would have little to gain.

However, Putin appears to have forgotten the lesson of his fallen Soviet comrades of the old communist order, and in meddling with world oil markets, he may have laid the foundations for his own economic demise.